Is there a Shariah-compliant form of risk transfer, since takaful and retakaful are based on risk-sharing principles? Mr Tobias Frenz of Munich Re shares some ideas to approach the dilemma from an actuarial perspective.
We actuaries can be a boring lot. Whilst others are indulging in E L James’ 50 Shades of Grey trilogy, many of us are often drawn to science books. One story that I find particularly fascinating is the story behind the quest in solving Fermat’s last theorem. Simon Singh’s Fermat’s Enigma and Amir D Aczel’s Fermat’s Last Theorem provide exciting accounts of the quest to solve the world’s greatest mathematical problem, ie, xn + yn = zn has no whole number solution for all n > 2. Princeton-based Andrew Wiles presented his proof of Fermat’s Last Theorem in 1993 at Cambridge University after working seven years on it. While he was applauded at first, a hole in the proof was found subsequently. Somewhat demoralised, he withdrew but finally emerged with a corrected proof one year later.
Professor Wiles summed up his seven-year quest as follows: “Perhaps I could best describe my experience of doing mathematics in terms of entering a dark mansion. You go into the first room and it’s dark, completely dark. You stumble around, bumping into the furniture. Gradually, you learn where each piece of furniture is. And finally, after six months or so, you find the light switch and turn it on. Suddenly, it’s all illuminated and you can see exactly where you were. Then you enter the next dark room…”
Personally, I bumped into furniture over and again when looking for a solution for a Shariah-compliant form of risk transfer for retakaful. Let me outline the dilemma in more detail below.
Dark room #1: To share or to transfer?
Retakaful and takaful are by definition based on cooperative, risk-sharing principles, whilst reinsurance and insurance are risk-transfer mechanisms. This is clearly laid out in Resolution No. 9 Concerning Insurance and Reinsurance of the Fiqh Academy in Jeddah (1985).
The crux of the matter for retakaful (and takaful) operators is the obligation to provide an interest-free loan (qard) to the retakaful pool if there is an underwriting deficit. The original intention of the qard was to overcome temporary cash flow shortfalls in the retakaful fund and was meant to be repaid rather quickly through future surplus arising in the retakaful pool.
A dilemma arises when future surplus is not sufficient to recuperate the loan. This is particularly relevant for retakaful as its main purpose is to assume peak risks, even more so for general retakaful, where volatile risks are covered and the contract is yearly renewable. The cedant can just walk away when a large claim has been incurred.
Any outstanding amount would then have to be borne by either the retakaful operator (by writing off the amount as impaired) or the participants of the retakaful pool (by providing funds to pay off the non-recoverable amount). The latter seems the most plausible option as the participants are the owners of the retakaful risk pool and the retakaful operator is a mere administrator that is not supposed to carry any risk.
However, in practice, this does not seem like a viable option in a commercial environment as ceding takaful operators are hardly willing to make good of any outstanding qard. The simple reason is that retakaful is still regarded as risk transfer in the first place by all takaful operators. A commitment to repay a qard after the end of a contract term would be a significant financial disadvantage if compared to taking up conventional reinsurance as the cedant would be exposed to potentially material financial qard repayments. Such a commitment would also have far-reaching accounting and reporting consequences.
Thus, the reality is that the shareholders of a retakaful company are bearing the full financial loss of a non-recoverable qard. This, in essence, is nothing but risk transfer and apparently forbidden from a Shariah perspective. However, regulators and scholars have been keeping one eye closed on this topic. While the regulator is driven by his primary actuarial objective to uphold policyholders’ security, Shariah scholars have yet to realise the scope of this dilemma as the technical understanding is often lacking.
Dark room #2: Are net rates Shariah compliant?
Retakaful operators face another problem when competing with conventional reinsurers that are quoting net reinsurance rates (or “non-par rates”), that is, rates with no surplus participation where any underwriting surplus and investment profit goes in full to the reinsurer. Currently, most retakaful operators use a fee-based agency (wakala) model where they have to share the underwriting surplus with the cedants in part (wakala-ju’ala) or in full, whilst a conventional reinsurer does not. Market competition requires both to quote the same rate for the same risks. It is obvious that retakaful operators charging non-par rates but offering surplus participation are not financially sustainable in the long run.
Can retakaful operators apply a different model to technically mirror net rates? There are four possible models I could think of to mirror net rates:
M1: Pure wakala model
Under a pure wakala model, the only way to achieve this is to charge an administration (wakala) fee of (close to) 100%. With (almost) nothing allocated to the retakaful risk pool, no surplus can arise. But M1 is a purely theoretical model as such a high wakala fee would be contentious from regulatory, Shariah, governance and accounting perspectives.
M2: Mudhararaba model
An alternative would be to apply a profit-sharing (mudharaba) model where 100% of any surplus goes to the manager, ie, the retakaful operator. However, it is unclear if Shariah scholars regard a 100% allocation as fulfilling the requirements of a mudharaba contract. Little is being written about such an extreme profit share in takaful.
However, a reference could be found in Bank Negara Malaysia’s (BNM’s) Shariah Standards for the Mudharaba and Musharaka contracts. For instance, BNM’s Mudharaba Standard page 13 reads: “PG 12.21 A party may waive his right to the profits, if any, to the other contracting party on the basis of waiver (tanazul) on the date of distribution of the profit.”
A 100% profit sharing thus seems viable, but only at the “on the date of distribution”, ie, it is only allowed if it is not pre-agreed. This contractual uncertainty at inception obviously is not an ideal model. But interestingly, BNM mentions in its Musharaka Standard that it is indeed possible if a unilateral promise (wa’d) contract is applied:
“54. A partner who has agreed to a certain profit sharing ratio may waive the rights to profits to be given to another partner on the basis of tanazul (waiver) at the time of profit realisation and distribution as well as at the time of the contract. However, a waiver of profit that takes place at the time of contract shall be by way of unilateral promise (wa’d).”
Accordingly, it is thus acceptable to agree at the time of contract on a waiver of surplus if the promise (wa’d) is combined with a waiver (tanazul).
Eureka! This seemed like a workable solution, but as will be seen later, combining Islamic contracts Lego-style to achieve the desired effect is not always possible under the Shariah.
M3: Hybrid wakala-ju’ala model
A more acceptable solution to a 100% mudharaba could be the following, although it achieves the same financial effect – a wakala-ju’ala hybrid model that combines the financial effects of the previous two models by charging both a wakala fee as well as a, say, close to 100% share in the underwriting surplus as performance incentive. There is no upper limit for the performance incentive under a ju’ala model as long as it is mutually agreed.
M4: Non-refundable claims reserve (CSR) concept
Lastly, the concept of a non-refundable CSR could be combined with any of the above models.
Munich Re Retakaful introduced this concept for non-proportional general retakaful risks in 2009, where 100% of the total retakaful fund surplus is distributed to a non-refundable CSR. At the dissolution of the retakaful pool, any positive balance in the CSR goes to the retakaful operator and not the pool participants or charity. This is to reflect the fact that the retakaful operation is carrying the full downward risk of an obligatory qard during the lifetime of the retakaful pool. It allows pricing on a non-par basis, which is for instance important for non-proportional cover.
The weakness of this model is that the treatment of a CSR under IFRS4 is uncertain and could be disallowed if the CSR would be seen as being akin to an equalisation reserve. However, it could also be treated as retained surplus as practised in Malaysia, which might be subject to deferred tax though.
Dark room #3: Blocking the means
The above models clearly stretch the limits of what a Shariah scholar might be comfortable with, although one can argue that this is permissible as long as the terms are mutually agreed upon under the freedom-to-contract principle. However, here is where Shariah scholars have a powerful “joker” card in their hand – the so-called “Blocking the evil means” maxim. The Islamic jurisprudence (fiqh) maxim sadd al-dhara’i’ (“blocking the means”) states that where a permissible action might lead to undesirable results, it shall be forbidden.
In this context, it would mean that if the retakaful operator takes 100% of the surplus, it will lead to the undesirable result of “permitting conventional insurance” as there is no more (perceived) “difference” between the two. Personally, I feel this is false logic or a rather emotional argument as surplus sharing is not an intrinsic and essential feature of takaful.
But I do recognise the thin line we are walking on when pushing the Shariah limits and we have to be mindful of the credibility of (re)takaful that is at stake. A scholar advised that simply more time is needed for scholars, practitioners and actuaries to digest and understand this topic to reach a consensus opinion on risk transfer.
The conclusion is that the room remains dark for the time being. It took Andrew Wiles seven years to find the first and another year to find the final switch. I’m hopeful that I can report of at least a feeble flame by 2015.
Mr Tobias Frenz is Managing Director, Retakaful & GCC – Life with Munich Re Underwriting Agents (DIFC) Ltd. The full-length version of this article was first published in The Malaysian Actuary (February 2013).